Preferred Issues: Convertibles Struggle for Market Acceptance

Unlike straight trust-preferred securities, convertible offerings have never taken off as a way for banks and thrifts looking to raise Tier 1 capital for regulatory purposes or acquisitions.

One reason has been the convertibles dilutive effect on per-share earnings, which makes them distasteful to holders of the companys common stock.

A landmark $1 billion deal by Washington Mutual Inc. that priced in late April was structured to avoid that very dilutive effect. If the Seattle thrift companys stock price, which fell nearly 6% on the day of the offering, is any indication, bankers wishing to take advantage of this vehicle for raising tax-deductible capital have yet to convert their shareholders to the idea.

Trust-preferred securities are hybrids with characteristics of debt and equity. Unlike most, Washington Mutuals can be converted into common stock. This feature is usually attractive to issuers because it allows them to offer a lower yield and still lure investors with the equity feature.

Wamu, the nations largest thrift company, priced $1 billion of 40-year trust-preferred convertibles using a proprietary structure created by sole manager Lehman Brothers. Participants in the offering received a warrant to purchase 0.8054 shares in Wamu stock when it reaches $62.08 for each security they purchase. The coupon was 5.375%.

Only two other financial institutions have issued convertibles this year: Neuberger Berman Inc., with a $151 million offering, and Affiliated Managers Group Inc., a Boston asset management company, with a $195 million deal, according to Thomson Financial Securities Data.

But the bankers say as more institutions and investors get comfortable with the structure, theres little not to like.

Because of the detachable warrants, the company can use an accounting treatment known as the treasury stock method to record the offering. Using this, the company needs to record only a small fraction of the shares that are ultimately issued.

There are no longer the issues regarding dilution that may have favored nonconvertible trust-preferred structures in the past, said Neil Sherman, a managing director in Lehmans equity capital markets.

In addition to more favorable accounting treatment, detachable warrants  instead of convertibles  mean that the bank receives an increase in its equity component up front worth 35% of the total issue.

With most other convertible products, this would not occur until conversion, Mr. Sherman said.

Bill Longbrake, Wamus chief financial officer, said the downside with the structure is that theres not the familiarity with investors in terms of the mechanics.

But even with increased understanding by equity investors about how these convertibles work, a nontechnical aspect of convertibles can still distract a companys stockholders.

The only other time Lehman has used this particular structure was in a $250 million deal for Sovereign Bancorp, which the Pennsylvania company issued as part of its leveraged acquisition of 268 FleetBoston Financial Corp. branches.

Mr. Longbrake said that the proceeds can be used in many ways, such as to support balance sheet growth or, given the right opportunity, an acquisition. However, thats not to say there is anything in the wings.

In addition, Wamu wanted to do the offering because it is a good thing from a ratings agency perspective, he said.

David Fanger, senior credit officer for Moodys Investors Services, said it considered Wamus equity to be at the low end of its peer group, but that this is not currently a negative factor in ratings.

The company faces a lot of other challenges that have greater impact, such as diversification, aggressive expansion, interest rate risk, and modest profitability, he said.

Mr. Sherman said convertible buyers were well oversubscribed to the offering. However, Wamus shareholders gave a cooler reception. The companys stock lost $3, or 5.6%, to close at $50.39 on April 20, the day the offering was announced.

Mr. Longbrake said the stock drop looked like a typical reaction to a convertible.

Wamu wasnt the only financial institution to get battered that day. The American Banker index of the top 50 banks fell 1.16%, while the index of the top 25 thrifts dropped 1.65%.

And since April 20, Wamus stock has regained most of the ground it lost, rising 5% to close at $53 Friday. The trust-preferred issues have been trading above a par of $50, between $50.50 and $50.75, a market source said.

Lehmans bankers said that the offering is unusual, not just for its size, but because its a trust-preferred convertible, and so naturally theres a learning curve among equity investors.

As more of these transactions are done for different kinds of companies, there will be increased awareness by equity investors of the structure, Mr. Sherman said.